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More Austrian Economics

 

Here is a perfect example of what I’ve been talking about regarding Austrian economists.  In this post, the author takes an observation that mainstream economists find puzzling and tries to convince you that it isn’t puzzling to Austrians and this is evidence that Austrian economics is superior.  But in the process he demonstrates total ignorance of mainstream economics, claiming that it does all sorts of things which it does not, and then proceeding to do exactly those things but in a simplified way that leads one easily into confusion.  Then he confusedly arrives at the conclusion that something puzzling actually makes perfect sense.

Let us begin by establishing what the endowment effect means.  The endowment effect is a phenomenon whereby an economic actor places a higher value on something if they own it than if they do not own it.  In other words their ordinal ranking of preferences changes merely because their endowment changes.  To put it in the form of an Austrian example, this means that a man who prefers an apple to an orange when he has an apple but not an orange may prefer an orange to an apple when he has an orange and no apple (holding all other things equal).  In either case he is not willing to trade.  Observing this should make you scratch your head no matter what economic philosophy you subscribe to, it’s just a thing that doesn’t make that much sense.  Look what I mean:

From a mathematical-economic point [sic] view, the endowment effect demonstrates the inability of formal economics to explain what drives human action. Indeed, the endowment effect seems to shift an actor’s indifference curves, and thus his subjective valuation of goods and services, depending not on qualities in the good itself or its price but on the contextual, circumstantial characteristics and psychological state of the instant and situation. The economic explanation to market valuation is therefore at odds with real valuation and the models need to be expanded to include psychological drivers of subjective valuation. And therefore economics must embrace behavioral studies and neuroscience.

He starts out correctly, well not the very start but once he says “the endowment effect seems to shift an actor’s indifference curves, and thus his subjective valuation of goods and services, depending not on qualities in the good itself or its price but on the contextual, circumstantial characteristics and psychological state of the instant and situation” he is saying something correct.  But this is not at odds with mainstream economic models.  There is no law in mainstream economics that subjective valuation can’t change based on “the contextual, circumstantial characteristics and psychological state of the instant and situation.”  It’s just that there isn’t much use in going around making models where people’s tastes change in random ways.  Therefore, classical consumer theory assumes that people’s tastes don’t change in the middle of the analysis.  This is not because we think people’s tastes never change it’s just that there is no way to base a scientific examination of human action on tastes which could be anything at any time.  But when we see tastes appearing to change in a systematic way that doesn’t seem logical we stop and scratch our heads and wonder what’s going on there.  We would like to come up with something better than just “well tastes change depending on whether or not you own something,” we want to find a logical reason why this would happen in a systematic way.  Maybe there isn’t one but it’s not crazy to wonder about.

On the other hand, we have here an Austrian who thinks he can explain it.  Here is a list of mistakes he makes.

1.  He is criticizing a study where people were given a coffee mug and asked what they would sell it for compared to people who were not given the mug and asked what they would pay for it. Per Bylund tries to claim that the observed effect is just a predictable residual brought about by rational exchange.  But this is not the endowment effect!  Nor is it what the study tested.  The endowment effect is not based on ex ante exchange.  By giving (or not giving) the mug to random people, the study eliminates this endogeneity.  In order for this model to even address the endowment effect it would have to explain something like: a farmer chooses not to buy a sack of grain for a price of $8 but then a robber sneaks into his house at night, steals $8 and leaves a sack of grain.  Then in the morning, the farmer is offered $8 for the grain but refuses.  Obviously, the model in this post does nothing to explain such a phenomenon.

2.  This statement: “The economic problem is what the price of that fourth sack would be.”  You can’t determine a price from looking at one economic actor.  The classical model assumes that prices are set by the market at such a level that the quantity supplied is equal to the quantity demanded.  Any individual buyer takes this price for granted and determines how much to buy.  But while this author seems to think that is a bad way to determine prices, his model offers absolutely no alternative.  He spends two paragraphs saying that he will pay up to his value of the good (this is the definition of value) and then assumes a price ($8).

3.  He then proceeds to claim that mainstream economics assumes that his value must be $8 because that is what he paid.  This is completely wrong.  The classical model (which is not the only mainstream model by the way) assumes that he can buy any quantity at a fixed price, that his marginal value of the good is decreasing as he gets more, and that he will do what maximizes his (subjective) utility.  This implies that he will choose the quantity that makes his marginal value equal to the price.  There are a lot if italics in the previous sentence because there are a lot of parts of it that the author clearly doesn’t really understand.  Mainstream economists don’t assume that nobody ever values anything more than what they pay, they just assume that marginal value is decreasing and continuous so they will keep buying it until their value of the last unit is equal to the price.  You may claim that these assumptions are not realistic but this Austrian model assumes that, for some reason, the person buys a quantity for which their marginal value of the good is greater than the price.  If this is the case, why don’t they buy more?  Perhaps you can think of an explanation but then ask yourself if that assumption is more universal than the ones in the classical model.  What’s more, even if this happens it doesn’t mean that $8 was his willingness to pay, his willingness to pay was $9, he just happened to be able to purchase the sack at a price which left him some consumer surplus.  He is the one equating value with price!

4.  Once he has assumed one person who bought an arbitrary quantity of a good at an arbitrary price and, by assumption, has a higher marginal value than that price.  He assumes that another person comes and asks what he would be willing to sell the sack for which he claims is $10 but this is not correct.  He would be willing to sell it for any price over $9.  The author seems to arrive at $10 simply by assuming that they can’t trade at any price in between.  In fact there is no endowment effect here.  The farmer is willing to pay any price up to $9 and willing to accept price down to $9.  His whole endowment effect is just the result of assuming discreet variables, with rather large increments, and assuming inaction when indifferent.  But even if these assumptions were all met, it wouldn’t be the endowment effect because his preferences didn’t change he just found himself in a situation where he had to stop buying the good before its marginal value was equal to the price.  This is, again, simply an assumption that the author makes and does not even attempt to explain.  Indeed, he is probably not even aware that he is making it.  This is the problem with not using math.

5.  This statement: “The value is not the price he is willing to pay to acquire it, and it is not the price he is willing to accept to give it up.”  This is in fact the definition of value.  So apparently his whole critique of mainstream economics is based on assuming definitions for words which are different from what mainstream economists mean by them.  No wonder he finds it confusing.

6. The very next sentence: “Exchange is not the result of an equality in valuation, as indifference-curve analysis assumes, but a result of inequality in the parties’ valuation.”  This is not what indifference curve analysis “assumes.”  It gets equality in valuation as a result of exchange which, as he says, is motivated by inequality in the parties’ valuation.  If exchange is motivated by inequality of values, then why does it stop when values are still unequal?

All of these problems are caused by a general misunderstanding of the classical model.  Especially prominent is a complete ignorance of the notion of diminishing marginal value, which is strange considering Austrians are constantly talking about “diminishing marginal utility” which they confuse for diminishing marginal value, or really of the word “marginal” in general.  This is not so surprising considering their refusal to do math.  But the really troubling thing is the constant assault on mathematics embodied in quotes like this:

Assuming “perfect” conditions and general equilibrium, the conclusions of economic analysis follow directly from the premises — as one would expect from solving mathematical equations — and are hence of little scientific interest.

This is completely backward and it is evidenced by the obvious confusion he falls into with his Austrian model.  The whole point of using math is that the conclusions follow directly from the premises.  This means you can’t make a mistake (assuming you are doing the math right) except in your premises.  Contrary to the Austrian notion, this isolates the premises as the important part of the process.  This forces those of us who deal in mathematical models to be very careful and specific about what we are assuming.  On the other hand Austrians have no universal logical framework to rely on so they are constantly asserting that something follows from something else but every step is open to debate.  This approach makes it very easy to make logical mistakes that lead one into confusion.  Worse still is the fact that it conceals all of the assumptions made implicitly along the way.  The simple model described in this post contains, as I have tried to point out, a great deal more assumptions than the classical model and most of them are a great deal more unrealistic.  All the while Austrians claim the classical model is useless because it assumes things that aren’t true in reality.  The whole point of a model is to simplify reality in order to better understand some aspect of it.  Mainstream economists do this.  Austrians do this.  The difference is that Austrians make models which are much simpler, therefore requiring more unrealistic assumptions, and don’t seem to realize that they are doing it.

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  1. December 29, 2011 at 8:47 pm

    I think I agree with your assessment, unfortunately.

  2. Free Radical
    December 29, 2011 at 9:23 pm

    Yes! You have no idea how hard I’ve been trying to get an Austrian to say that. I actually love you guys but I wish you wouldn’t be so sloppy with your economics….

  3. Free Radical
    December 29, 2011 at 9:26 pm

    Sorry I looked over the comments again and you were basically on my side to begin with, so the mission continues but I till appreciate the support. (=

  4. December 29, 2011 at 9:45 pm

    Yep. I’m not an Austrian, though I like some bits of Austrian economics. But that comment thread was just,…..sad. Hang in there.

  5. Free Radical
    December 29, 2011 at 9:51 pm

    Haha, thanks it’s nice not being alone.

  1. February 24, 2013 at 8:42 am

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